Sectors

Neutral U.S retailers have reported excellent sales numbers in the most recent quarter, most notably Walmart that delivered a surprising 3.4% same store sales growth number; the market has responded in kind and spared the S&P hypermarkets index that has held up well vs. the broad equity market. Still, this outperformance seems anecdotal as hypermarkets have struggled to gain traction against other retailers. Likely, higher consumer wages are being deployed elsewhere (second panel). With a savings rate that is still elevated relative to history (third panel), the consumer has significant dry powder to deploy, but this appears to have little bearing on hypermarkets and their less discretionary consumption offering. This suggests an absence of a margin lever, which is reflected in the accelerating downward trend of S&P hypermarkets EPS growth relative to the broad market (bottom panel). Net, despite the market's sanguine view on the operating performance of hypermarkets, we prefer to stay on the fence. The ticker symbols for the stocks in this index are: BLBG: S5HYPC - WMT, COST.    

Overweight The recent carnage in oil markets has breathed a huge sigh of relief into the S&P airlines index (most of which do not hedge fuels costs) as the collapse in WTI crude oil prices has also taken down kerosene prices. As we noted in our early-summer report when we added an upgrade alert to this sector, a letup in jet fuel prices would be the catalyst for a change in view1; we executed this upgrade in Monday's Weekly Report. The second panel of our chart shows that input cost relief will be a key driver of a rebound in relative airline profits in the coming months. However, not only will airlines get a boost from falling jet fuel prices, but also demand for travel remains upbeat. Consumer confidence is sky high and consumer spending is running at a healthy clip, at a time when job certainty is high and wage inflation is making a comeback (third and bottom panels). Adding it up, it no longer pays to be bearish airlines. Firming pricing power on the back of recovering demand coupled with input cost deflation suggest that an earnings led recovery in the S&P airlines index is in order. Bottom Line: We crystallized gains of 18% since inception and lifted exposure to an above benchmark allocation on Monday, please see our Weekly Report for more details. The ticker symbols for the stocks in this index are: BLBG: S5AIRL - DAL, LUV, UAL, AAL and ALK. ​​​​ 1 Please see BCA U.S. Equity Strategy Insight Report, "Could Jet Fuel Be The Tailwind Airlines Need?" dated June 6, 2018, available at uses.bcaresearch.com.

Special Report

Highlights U.S. housing's immediate past will not repeat, ... : It is understandable that investors who lived through the financial crisis are acutely sensitive to any sign of trouble in housing, but none of the factors that helped precipitate the crisis are in place now. ... and its older history will only rhyme: Home construction slowdowns have a good record of signaling recessions, but residential investment's steadily waning share of GDP has chipped away at its influence. The current housing soft patch is not over, but it's unlikely to get much worse, ... : The rapid rise in mortgage rates sharply reduced affordability, but it still remains at a very comfortable level relative to history. Inventories of new and existing homes are very low, and the pace of new construction continues to run slightly behind household formation. Most importantly for the expansion, there were no construction excesses in this cycle that need to be worked off. ... so we don't think it's sending any broader signal about the economy: A tiny contraction in residential investment is not a harbinger of recession, nor is it an indication that monetary policy is already tight. Feature Desynchronization has been the name of the game in 2018. The U.S. economy, already ahead of its peers in putting the crisis in its rear-view mirror, has gotten an additional fillip from the fiscal stimulus package. Global growth, on the other hand, has been slipping. As Fed chair Jay Powell put it last week, the rest of the world is "gradual[ly] chipping away" at the U.S., but there "is not a terrible slowdown" in the global ex-U.S. economy. Global conditions have not slowed enough to get the Fed to interrupt its tightening campaign, but signs of softness outside of the U.S.'s borders have been popping up like mushrooms after the rain. With disappointments having been few and far between in the U.S., any pockets of weakness that do appear attract immediate attention. Against this backdrop, the slowing in housing - residential investment has now contracted for three consecutive quarters - is making some investors a little uneasy. We have spent a good deal of time within BCA debating housing's recent softness, its outlook, and its implications for financial assets and the economy, and clients are increasingly inquiring about our views. Housing's Recent Past Housing is top of mind for many investors because it was at the center of the financial crisis. Residential mortgages were ground zero of the credit bubble that systemically threatened the banking system. Wobbles in housing bring back unpleasant memories of the searing trauma that unfolded just ten years ago. With the dot-com mania and the financial crisis having occurred just a decade apart, the financial media, and many strategists, analysts and investors are on high alert for the next crash. The concerns are understandable, but conditions today are nearly the polar opposite of conditions in 2005 and 2006. There is nothing even remotely bubble-like about the current housing market. The critical weakness back then was the shunning of time-tested underwriting standards, as revealed by the homeownership rate. An average of just over 64% of households owned their own homes for the first three decades of the ownership series in a remarkably steady pattern,1 but a steady debauching of standards pushed the rate to above 69% at its peak (Chart 1, top panel). Chart 1Too-Easy Lending Standards ... The homeownership rate was built on a foundation of increasingly unserviceable mortgages (Chart 1, bottom panel). Prices surged (Chart 2, top panel), flippers flooded the market, and homebuilders ramped up production to meet the ensuing demand (Chart 2, second panel). When the music stopped, the housing market was left with unprecedentedly large inventories of unsold homes (Chart 2, third panel); the banking system's primary source of collateral was poised to suffer a body blow; and a hiring surge that played out over a decade and a half was unwound in just two years (Chart 2, bottom panel). Chart 2... Made Housing Unstable Housing In The Current Cycle Current conditions are much more stable. The homeownership rate is back to its time-tested levels. New housing supply has generally undershot the smoothed trend in household formations ever since the crisis ended (Chart 3, top panel). Inventories are strikingly low when adjusted for the overall size of the housing stock (Chart 3, middle panel). The vacancy rate is low (Chart 3, bottom panel), and there is no construction employment cliff. Most importantly from a stability perspective, the Basel III/Dodd-Frank regulatory framework makes it very difficult to replicate the reckless credit conditions that enabled the housing bubble. This cycle has been devoid of housing excesses. Chart 3Plenty Of Room For More Homes A broader historical context reveals that housing has been exerting steadily less influence on the economy across the entire postwar era. We have a good deal of sympathy for the argument that the postwar business cycle has been a consumption cycle, largely led by housing,2 but it's possible that the crisis marked housing's last hurrah as a driver of recessions. Residential investment's share of GDP exploded when pent-up demand was released upon the return of servicemen and women needing homes for their burgeoning families (Chart 4). The construction of the interstate system, and the network of subsidiary roads that sprang up to connect to it, facilitated the creation of the suburbs, and Levittown-style tract housing communities had to be built from scratch to meet the demand. Chart 4The Incredible Shrinking Impact Of Housing Activity The baby boom kept demand for more, and larger, houses going strong. Once grown themselves, the baby boomers helped keep household formation growth flush. The baby boomers are now net sellers, however, and will be at an increasing rate across the next couple of decades. The time trend of residential investment's share of GDP is stark, and demographics are poised to keep it going as long as the baby boomers are divesting their holdings. The bottom line is that we do not think housing is the business cycle this time around. It is a highly cyclical part of the economy, and its fluctuations will still be felt, but its influence on the overall economy has been steadily waning for 70 years, and it is not currently in a position to exert a powerful drag. It would be overstating matters to say that housing booms cause recessions, but they've been observed at the scene of the crime in every recession of the last 60 years except for the dot-com bust. In this cycle, the barely visible white area above the trend line in Chart 4 is nowhere near large enough to give rise to a big swing below the trend line, and inspire a patch of gray shading on its own. The ratio of housing starts to the existing stock of homes (Chart 5) reinforces the message of residential investment's declining contribution to overall output. The United States has been augmenting and/or replacing the existing stock of homes at a steadily diminishing rate for 60 years. Assuming that the rate of obsolescence has remained roughly constant, it seems that there has simply been less to build once the suburban frontier was settled. Even against the declining time trend, however, residential construction activity in this cycle has not revived enough to require a correction. Chart 5Tinkering Around The Edges We attribute the current softness to the backup in mortgage rates over the last twelve months. 100 basis points may not seem like the end of the world, but the rise in interest rates has been sudden, and it is entirely plausible to think that it has sent some marginal first-time buyers to the sidelines. The Housing Affordability Index is way below its 2013 peak, but remains quite high relative to its pre-ZIRP history (Chart 6, top panel). The sudden drop in the index has been a function of mortgage payments (Chart 6, second panel) as sudden moves almost always are - the median home price (Chart 6, third panel) and the median income series (Chart 6, bottom panel) are much less variable. Chart 6Mortgage Rates Drive Affordability We expect that rates will go still higher, but our bond strategists don't think it will happen any time soon. They see rates consolidating for a while as the economy digests the sharp move higher, and favorable year-over-year comparisons cool off inflation's upward momentum over the coming months. Our above-consensus view on the terminal fed funds rate is not housing friendly. Housing will have to contend with ongoing bond-market headwinds, but we don't expect another move of this magnitude will recur in such a concentrated time frame. Bottom Line: Housing may face a headwind from higher rates for at least another year, but a big drop-off in activity is not in the cards. There are no current cycle excesses that need to be unwound, and housing has become too small a part of the economy to induce a recession on its own. Housing Demand And The Fed Funds Rate Cycle The notion that mortgage rates are to blame for the housing soft patch raises some questions about our assessment of the monetary policy backdrop. Is it possible that a funds rate that's proximally related to a slowdown in housing demand is not impacting consumer demand for other goods or services, or corporate demand? Could there be multiple equilibrium fed funds rates? If not, is the housing soft patch a sign that the economy is actually in Phase II of the cycle, and not Phase I? We are unperturbed by the three-quarter contraction in residential investment, which one has to squint to see (Chart 7). We do not believe that housing demand has reached an inflection point; we simply think that prospective monthly mortgage payments have moved so fast that some buyers have temporarily stepped aside. Given that buying a home still looks quite inviting by the historical standards of the affordability index, conditions are not yet restrictive. Ex-the ZIRP era, the index had not exceeded 140 for more than three decades (Chart 6, top panel). If homes are still affordable relative to history, then housing would seem to support our equilibrium fed funds rate model's assessment that monetary policy remains accommodative. Chart 7Not Much Of A Downturn Yet We view the state of policy as binary for the economy as a whole, even if some activity is necessarily more rate-sensitive. While some marginal investment projects cease to generate positive prospective net present value any time interest rates rise, encouraging or discouraging activity is a universal condition. The broader investment-relevant question is whether or not our assessment that the fed funds rate cycle has not yet transited from Phase I to Phase II is correct (Chart 8). If the economy is still in Phase I, and will remain there for a year, our constructive take on the economy and financial markets still applies. If it's shifted to Phase II, however, the empirical record says investors should be paring back risk. Chart 8The Fed Funds Rate Cycle The preponderance of evidence supports the idea that we remain in Phase I. Real-time measures of activity remain robust. Credit performance remains very good, so banks are still eager lenders. Employment is surging, and a follow-up dose of fiscal stimulus in 2019 should keep all the plates spinning for another year. As macro investors, and students of cycles, we are as eager as anyone to recognize the inflection point as swiftly as possible, but the data series we follow do not indicate that it is approaching. We continue to abide by our equilibrium fed funds rate model's benign conclusion. Investment Implications Although housing's direct impact on GDP has steadily waned, it remains an important part of the economy, given how it feeds into several other elements of consumer demand. Three consecutive quarters of contraction in residential investment are worthy of notice, but such a run has occurred before without provoking a recession, and the contraction to date has been awfully modest in any event. We do not view the slowdown as the beginning of the end for the expansion. We also do not view it as a sign that monetary policy is tighter than we originally judged. We expect that the ongoing surprise over the rest of this cycle will be that the neutral fed funds rate is considerably higher than the market consensus expects. We therefore think that investors should continue to maintain benchmark exposure to risk assets while remaining underweight Treasuries and holding all bond exposure below benchmark duration. Since we think the expansion remains in place, supported by accommodative monetary policy, we view the recurring mini-scares provoked by data points like housing's soft patch as potential opportunities to put our cash overweight to work. Doug Peta, Senior Vice President U.S. Investment Strategy dougp@bcaresearch.com 1 Over the 120 quarters through the end of 1994, a mean 64.3% of households owned a home, with a standard deviation of 0.6%. Only 22% of the quarterly observations were more than a standard deviation away from the mean, as opposed to the 32% predicted by the normal distribution. 2 Leamer, Edward E., "Housing IS the Business Cycle," NBER Working Paper No. 13428, September 2007. http://www.nber.org/papers/w13428

Dear Client, Next week on November 26th instead of our regular weekly publication you will receive our flagship publication “The Bank Credit Analyst” with our annual investment outlook. Our regular publication service will resume on December 3rd with our high-conviction trades for 2019. Kind regards, Anastasios Avgeriou Highlights Portfolio Strategy We maintain our sanguine U.S. equity market view for the coming 9-12 months and reiterate our conviction that it is a good time to deploy longer-term oriented capital. The signal from our Economic Impulse Indicator represents a yellow flag and we will continue to monitor the economy for additional soft-patch signals, especially as the Fed remains committed to tighten monetary policy three more times by mid-2019. Firming pricing power on the back of recovering demand coupled with input cost deflation suggest that an earnings led recovery in the S&P airlines index is in order. Take profits and boost to an overweight stance today. Burgeoning domestic demand for freight services, healthy industry operating metrics, the recent margin boost owing to the crude oil price collapse along with compelling valuations and technicals, suggest that the path of least resistance is higher for the S&P air freight & logistics group. Recent Changes Book gains in the S&P Airlines index of 18% since inception and lift from below benchmark to overweight today. Table 1 FEATURE The SPX was rudderless last week, as the tug-of-war between bears and bulls has yet to be decided. Equities have been experiencing mini-aftershocks following October's seismic move because the Fed has injected some volatility back into the markets via raising interest rates and allowing bonds to roll off its balance sheet at an accelerating pace. While the Fed stayed pat in November, it will most definitely tighten monetary policy next month for the ninth time this cycle. Fed policy is at the epicenter of recent S&P 500 oscillations, which raises the question: is the Fed tightening monetary policy too far too fast to cause equity market consternation? To put the latest monetary tightening cycle in perspective, we examined trough-to-peak moves in the fed funds rate since the 1950s. Chart 1 shows the results of our analysis. During the past ten Fed tightening cycles, the median trough-to-peak delta in the fed funds rate heading into recession has been 495bps. The latest cycle that commenced in December 2015 is already 25bps above the median, if one uses the Wu-Xia shadow fed funds rate to capture the full quantitative easing effect (Chart 2). Were the Fed to hike three more times by the first half of 2019, as our fixed income strategists expect, this will push the current cycle 100bps above the historical median. Chart 1Too Far Too Fast? Chart 2Trough-To-Peak Tightening Cycle Already Above Historical Median While almost everyone raves about the stellar U.S. economic performance squarely focused on levels of different economic indicators (Chart 3), drilling beneath the surface reveals that small cracks are forming, as we first highlighted in the October 22nd Weekly Report when we introduced our Economic Impulse Indicator (EII).1 The EII is a second derivate equally-weighted composite of six indicators of the U.S. economy, highlighting that peak economy was likely hit this year in Q2, when nominal GDP grew 7.6% on a quarter-over-quarter annualized growth rate basis. Chart 3Do Not Focus On Levels Alone... Chart 4 shows that 5 out of the 6 indicators included in the EII are losing steam, 4 out of 6 are in outright contraction, and only capex is showing modest signs of life. While this backdrop in isolation does not portend recession, were the Fed to go ahead with three additional hikes by mid-year 2019 that would push the fed funds rate to a range of 2.75%-3% and a possible negative Q2/2019 GDP print could then easily invert the yield curve, ticking the box in one of our three recession indicators we track.2 Chart 4...Impulses Tell A Different Story The latest Fed Senior Loan Officer survey released last week also struck a nerve. While bankers are willing extenders of credit throughout most loan categories, demand for loans is declining across the board (Chart 5A); only other consumer (likely student) loans are in high demand, and subprime residential loans are also threatening to break above the zero line.3 Nevertheless, before getting too bearish, a bond valuation examination is in order. BCA's 10-year bond valuation index has been an excellent predictor of cycle ends dating back to the 1960s. It has accurately forecast 6 out of the last 7 recessions missing only the 1974 iteration. When this valuation metric swings to extremely undervalued territory - defined as at least one standard deviation above the historical mean - it signals that a recession is approaching. Why? Typically a selloff in the bond market is associated with a fed tightening cycle and such steep monetary tightening slams the breaks on the economy via the slowing housing market and the dent in consumer spending power. True, we are closing in on this level, but we are not there yet (Chart 5B). Chart 5ALoan Demand In Freefall Chart 5BWatch Bond Valuations Finally, we bought the proverbial dip on October 26th as we did not (and still do not) foresee recession in the coming 9-12 months, underscoring that likely the trough is in place.4 On that front the Minneapolis Fed's implied probability of a 20%+ correction remains tame near the 10% probability mark, corroborating our sense that the worst is behind the equity market, at least for now (Chart 6). Chart 6Risk Of A Bear Market Is Low Netting it all out, we maintain our sanguine equity market view for the coming 9-12 months and reiterate our conviction that it is a good time to deploy longer-term oriented capital. The signal from our EII represents a yellow flag and we will continue to monitor the economy for additional soft-patch signals especially as the Fed remains committed to tighten monetary policy three more times by mid-2019. This week we crystalize gains in the smallest transportation sub-index we cover and boost exposure to overweight, and reiterate our high-conviction overweight stance on a large transportation sub-index. Airlines: Up In The Air Within transports we have been advocating a barbell portfolio preferring air freight & logistics (see below for an update) to airlines (as a reminder we recently downgraded rails to neutral5). The recent carnage in oil markets has breathed a huge sigh of relief into the S&P airlines index (most of which do not hedge fuels costs) as the collapse in WTI crude oil prices has also taken down kerosene prices. Chart 7 shows that input cost relief will be a key driver of a rebound in relative airline profits in the coming months. Thus, we are compelled to trigger our upgrade alert and cement gains of 18% in our underweight and lift exposure to overweight in the niche S&P airlines index. Chart 7Energy Price Plunge Is Bullish For Airline EPS Not only will airlines get a boost from falling jet fuel prices, but also demand for travel remains upbeat. Consumer confidence is sky high and consumer spending is running at a healthy clip, at a time when job certainty is high and wage inflation is making a comeback (Chart 8). Chart 8Air Travel Demand... In fact, a larger proportion of the consumer's wallet is used for air travel, a trend that has been recently gaining steam according to national accounts. Airline load factors are pushing cyclical highs and passenger revenue per available seat mile is also gaining momentum, corroborating the U.S. government consumption expenditure data (Chart 9). Chart 9...Is Upbeat... As a result, airlines have been successful at raising selling prices and will soon exit the deflationary zone. International airfares are also in positive territory. Taken together, robust demand and higher selling prices along with declining fuel costs are a harbinger of rising margins and profits (Chart 10). Chart 10Firming Ticket Prices Is A Boon To Margins This is not yet reflected in depressed relative forward sales and profit growth estimates. Net earnings revisions have also recovered to the zero line and there is scope for additional positive EPS revisions, especially if jet fuel prices stay tamed and travel demand remains healthy. The implication is that relative share price momentum can lift off further (Chart 11). Chart 11Low Hurdle Finally, valuations are perched deeply in the undervalued zone while technicals have only recently returned to a neutral setting (Chart 12). Chart 12Unloved and Under-owned Adding it up, it no longer pays to be bearish airlines. Firming pricing power on the back of recovering demand coupled with input cost deflation suggest that an earnings led recovery in the S&P airlines index is in order. Bottom Line: Take profits in the S&P airlines index of 18% since inception and lift exposure to an above benchmark allocation. The ticker symbols for the stocks in this index are: BLBG: S5AIRL - DAL, LUV, UAL, AAL and ALK. Air Freight & Logistics: We Have Liftoff Air freight & logistics stocks have been bouncing along the bottom for the better part of the past year and have formed a base that should serve as a launch board higher in the coming months. Firming industry operating metrics tell a positive story and suggest that relative share prices will soon take off. Air freight pricing power has been healthy, in expansionary territory and above overall inflation measures, at a time when industry executives have been showing labor restraint, with employment growth decelerating steadily over the past two years (Chart 13). This is a conducive backdrop for air freight profit margins and sell-side analysts have taken notice, penciling in higher margins in the coming 12 months. Chart 13Enticing Margin Prospects Importantly, energy costs comprise a large chunk of freight services input costs and the recent drubbing in oil markets will boost margins especially on the eve of the busiest season for courier delivery services (top panel, Chart 14). Chart 14Holiday Selling Season Beneficiary On that front, there are high odds that this holiday sales season will be another record setting one, especially given that corporations have paid out bonuses and shared part of the lowering in corporate taxes and also wage inflation is underpinning discretionary incomes. Keep in mind that the accelerating domestic manufacturing shipments-to-inventories ratio confirms that demand for hauling services is upbeat. The implication is that rising demand for freight services will buoy industry profits and lift valuations out of their recent funk (middle & bottom panels, Chart 14). With regard to the global macro and trade backdrop, while global revenue ton miles and G3 capital goods orders remain near cyclical highs (Chart 15), were Trump's trade rhetoric to re-escalate then global exports would give way. Already international and U.S. export expectations are on the verge of contracting - according to the IFO World Economic Survey and ISM manufacturing survey, respectively. Tack on the appreciating U.S. currency and the clouds darken further (bottom panel, Chart 15). The U.S./China trade tussle and the greenback are clear risks to our sanguine S&P air freight & logistics transportation subindex. Chart 15Greenback And Decelerating Global Growth Are Key Risks... Nevertheless, most of the grim news is already reflected in depressed relative forward profit estimates, bombed out valuations and washed out technicals. In sum, firming domestic demand for freight services, healthy industry operating metrics, the recent margin boost owing to the crude oil price collapse along with compelling valuations and technicals suggest that the path of least resistance is higher for the S&P air freight & logistics group (Chart 16). Chart 16...But Already Reflected In Depressed Valuations And Washed Out Technicals Bottom Line: We reiterate our high-conviction overweight status in the S&P air freight & logistics index. The ticker symbols for the stocks in this index are: BLBG: S5AIRF - FDX, UPS, EXPD and CHRW. Anastasios Avgeriou, Vice President U.S. Equity Strategy anastasios@bcaresearch.com 1 Please see BCA U.S. Equity Strategy Report, "Icarus Moment?" dated October 22, 2018, available at uses.bcaresearch.com. 2 Ibid. 3 https://www.federalreserve.gov/data/documents/sloos-201810-charts.pdf 4 Please see BCA U.S. Equity Strategy Insight Report, “Time To Bargain Hunt” dated October 26, 2018, available at uses.bcaresearch.com. 5 Please see BCA U.S. Equity Strategy Report, "Critical Reset" dated October 29, 2018, available at uses.bcaresearch.com. Current Recommendations Current Trades Size And Style Views Favor value over growth Favor large over small caps

Underweight In early-2018, some green shoots appeared for telecom services that an end was in sight for the nearly two years of pricing deflation hitting industry profits as some year-on-year pricing gains were eked out. However, as shown in the second panel of the chart, those year-on-year gains have petered out and, in fact, pricing is in deflation again on a three-month rate of change basis. At the same time, industry wages have fully reversed their declines and have accelerated for the past year (third panel). The combination implies increasing margin pressure, which is reflected in sell-side earnings growth estimates continuing to underperform the broad market (bottom panel). Tack on the tight inverse correlation between the high dividend yielding telecom services stocks and the 10-year yield, paired with BCA's expectation for rising yields, and the ingredients are all in place to remain bearish; stay underweight the S&P telecom services index. The ticker symbols for the stocks in this index are: BLBG: S5TELSX - T, VZ, CTL.